Stock Topping Valuations

The prevailing valuations in the lofty US stock markets are increasingly becoming
a bone of contention. Wall Street calmly asserts stocks are reasonably valued,
since it has a huge vested interest in keeping people fully-invested. But with
valuations soaring following a massive rally and weak third-quarter earnings
season, they are dangerously high and portend great downside risk. Stock topping
valuations abound.

Since investing is all about buying low then selling high, the price paid
for any investment is everything. Buy good companies at cheap prices,
and you'll multiply your wealth over time. But buying those very same good
companies at expensive prices radically stunts future gains. While cheap investments
have great potential to soar as traders recognize their inherent value, expensive
ones have already exhausted their upside.

And it's valuations, not absolute stock prices, that define cheap and
expensive. Valuations are where stock prices are trading relative to their
underlying corporate earnings streams. The less investors pay in terms of stock
price for each dollar of profits, the greater their ultimate returns. Valuations
are most often expressed in price-to-earnings-ratio terms, with stock prices
divided by underlying corporate earnings per share.

This concept is so easy to understand, yet the vast majority of investors
ignore it. Imagine purchasing a house for a rental property that has expected
annual rental income of $30k. How much would you be willing to pay for it?
If you can get it for $210k, 7x earnings, it will pay for itself in just 7
years. That's a great deal. But if that same house is priced at $630k, 21x,
it will take far too long just to recoup the initial cost.

The stock markets work the same way, with each dollar of profits completely
fungible. And the US stock markets have a century-and-a-quarter average
P/E ratioof 14x earnings. That's fair value for the stock markets
as a whole, paying $14 in stock price for each $1 of underlying corporate earnings.
This makes a lot of sense, as stock markets exist to "lend" capital from those
with surpluses of it to others running deficits.

The reciprocal of 14x earnings is 7.1%. That's a fair rate of return for those
with excess savings they want to invest, and a fair price to pay for those
who want access to that scarce capital. 14x facilitates mutually-beneficial
transactions for each side of the capital trade, so it's right where stock
valuations have naturally gravitated towards over the very long term. Cheap
and expensive are defined from that baseline.

Half fair value, or 7x earnings, is very cheap historically. Buying good companies'
stocks trading at 7x earnings is a virtual guarantee of massive wealth-multiplying
future gains. Conversely double fair value, 28x, is exceedingly-dangerous bubble
territory. Buying the same good companies' stocks at 28x dooms invested capital
to many years of lackluster gains at best, and catastrophic losses exceeding
50% at worst.

There's nothing more important for investors to understand than general-stock-market
valuations. They move in great third-of-a-century cycles I call Long
Valuation Waves. These are divided into secular bulls and secular bears
that each last about 17 years. Valuations start out cheap near 7x, gradually
expand to or through 28x in the first-half secular bulls, and then consolidate
back to 7x in the second-half secular bears.

Unfortunately the US stock markets remain mired deep in the valuation-contracting secular-bear
phase of their LVW today despite their epic cyclical bull of recent years.
How can that be true when the US stock markets have more than tripled since
early 2009? The flagship S&P 500, despite its massive gains, still
remains below its real
inflation-adjusted peak from the end of the last secular bull
way back in March 2000!

The last cyclical bull peaked in October 2007, and ominously the US
stock markets are trading at far-higher valuations today than they were back
then. This first chart looks at general-stock valuations as seen through the
lens of the benchmark S&P 500, or SPX. Our methodology is simple, conservative,
and easy to replicate. At each month-end, we record some key data from all
500 SPX component companies.

Each individual stock price is divided by that company's latest four quarters
of accounting earnings per share as reported to the SEC, yielding individual
P/E ratios for all 500 SPX components. This is classic trailing-twelve-month methodology,
involving hard historical data and no guesswork on future profits. Then all
500 of these P/Es are averaged, both simply and also weighted by individual
companies' market capitalizations.

Here are the results since the topping of the last cyclical bull, with SPX
valuations recently surging up to lofty nosebleed levels. Contrary to Wall
Street's endless claims that the stock markets aren't expensive today, prevailing
valuations are actually way up at dangerous bull-slaying levels. The
SPX and therefore US stock markets are trading at topping valuations today,
which is a super-bearish omen going forward.

While I'm eager to see November's valuation data, this month isn't quite over
yet. So our latest SPX valuation data is from the end of October. And that
proved pretty ominous, with the market-capitalization-weighted-average price-to-earnings
ratio of all 500 SPX component stocks rocketing 17.5% higher on a monthly
basis to 25.5x earnings! These elite companies' simple-average P/E ratio
was right in line at 25.6x.

This was a huge jump in valuations in such a short period of time, an exceedingly-rare
event. It had two primary drivers. First, the mighty S&P 500 rocketed an
epic 8.3% higher in October, its best month since October 2011! Assuming constant
corporate profits, any stock-price gains translate directly into proportionally
higher price-to-earnings ratios. Up the P/E ratio's P by any percentage, and
the P/E will match that gain.

But that only accounts for about half of October's extreme valuation
ramp. The other half came from a weak third-quarter earnings season. While
there were certainly some great results from elite technology companies, the
great majority of SPX components saw flat-to-weak profits year-over-year. There
were mounting worries of a bifurcated economy, the tech giants thriving
while most of the rest of the companies struggle.

Lowering the E in P/E naturally forces valuations higher as well. And it's
pretty amazing lower earnings actually came to pass. It's not overall corporate
profits that feed P/E ratios, but earnings per share. The great majority
of elite SPX companies actively manipulate EPS higher through stock buybacks.
If overall profits can be spread across fewer outstanding shares, the EPS will
rise which will force valuations lower.

And thanks to the Fed's extreme zero-interest-rate policy held in place since
the dark heart of 2008's stock panic, corporations literally borrowed trillions
of dollars near artificial record-low rates to use to buy back their stocks.
As of the end of Q2'15, total buybacks over that past year alone had exceeded
$555b! And a whopping 3/4ths of the elite SPX companies, the biggest and best
in America, bought back their stocks.

These campaigns are explicitly designed to simultaneously boost stock prices
and earnings per share, which creates an illusion of growth. Companies
can even mask declining earnings by buying back enough shares to more than
offset the drop in profits spread across them. And this outright earnings-per-share
manipulation that lowers valuations makes this past year's valuation ramp
even more ominous.

A year ago in October 2014, the elite SPX component companies had a market-capitalization-weighted-average
P/E ratio of 22.8x. Weighting all components' P/E ratios by their market caps
ensures smaller companies with outsized valuations don't disproportionately
skew the overall average. And the SPX ended that year-ago October at 2018,
which was actually pretty close to the 2079 closing out October 2015.

With the SPX merely climbing 3.0% in that year ending October, it's incredible
that valuations still shot up by 11.5% despite those massive stock buybacks!
This implies corporate earnings have peaked this past year, which helps
explain these grinding toppy stock markets. If companies fail to even maintain
their profits, then today's lofty stock-market valuations based on future
earnings growth look even more threatening.

Trading at 25.5x earnings last month, the SPX was right on the cusp of exceedingly-dangerous bubble
territory at 28x earnings! No valuations remotely close to this had been
seen in over a decade. Even back in October 2007 when the last cyclical bull
peaked, the SPX valuation was considerably lower at 21.3x earnings. Yet stocks
were still expensive enough to roll over from cyclical bull to cyclical bear.

Valuations are the key arbiter of those great bull-bear cycles in the stock
markets. When stocks grow expensive by historical standards late in mature
bull markets, the odds mount that a new bear market looms. And investors lulled
into a dangerous sense of complacency at these critical times by Wall Street's
perpetually-bullish rationalizations of why stocks should rally forever face
devastating bear-market losses.

After that last cyclical bull peaked in October 2007 at merely 21x earnings,
the mighty S&P 500 would plunge 56.8% over the next 1.4 years in a brutal
cyclical bear. Investors owning the best-of-the-best elite American companies
constituting the SPX saw their capital more than sliced in half because
they failed to heed the warning of high valuations. And today's are more extreme, nearly
20% higher than that last bull top!

Remember that for a century and a quarter, the average P/E ratio of the US
stock markets has been 14x earnings. The white line in these charts reveals
where the SPX would need to trade to match this historical fair-value baseline.
And as of the end of October, this number is way down under 1150. With
the US stock markets so expensive, the downside as these lofty valuations inevitably
mean revert is massive.

The stock markets would have to drop 45% based on current corporate
earnings per share, even boosted by the gargantuan ZIRP-spawned stock buybacks
in recent years, to merely return to fair value! This is an interesting number,
because the typical decline in cyclical stock bears following cyclical stock
bulls at this stage in the market cycles is 50%. The recent stock topping valuations
are very menacing indeed.

For years, Wall Street has endlessly claimed these lofty Fed-levitated
stock markets are justified based on underlying corporate-earnings fundamentals.
For years, Wall Street has applauded the manipulative stock buybacks that
artificially boost earnings per share. All this has led to extreme complacency,
with most investors convinced this long-in-the-tooth bull market can continue
indefinitely. Boy will they be surprised.

And even worse, the downside target for the next S&P 500 bear is actually
much lower than fair value. At this stage in those great Long Valuation Wave
stock-market cycles, valuations actually ought to be much closer to 10x earnings.
This next chart, which zooms out to encompass the entire secular bear since
2000, illuminates this enormous downside risk created by the Fed's brazen
artificial stock-market levitation.

The US stock markets remain mired deep in the same secular bear that started
back in March 2000. How can that be when the S&P 500 peaked at 1527 back
then and recently soared to 2131 in May 2015? If the March 2000 apex of the
last secular bull is adjusted for US Consumer Price Index inflation, which
is even lowballed
for political reasons, it works out to 2122 in constant May 2015 dollars.
That's a staggering revelation.

For 15.2 years, the US stock markets did nothing but grind sideways at
best in real terms! For all the sound and fury of the Fed's extraordinary
stock-market levitation of recent years fueled by its unprecedented third
quantitative-easing campaign, all it accomplished was returning the stock
markets to their last real secular-bull peak. But not even the Fed's epic
money printing could create a solid corporate-profits foundation.

October's near-bubble 25.5x SPX valuations were last seen 11.3 years earlier
in June 2004. And those were right on the major secular-bear stock-valuation
downtrend shown above with the thick blue dotted line. That valuation downtrend
is exceedingly important, and actual valuations oscillated around it as usual
in secular bears until late 2012 when the Fed launched and expanded its infamous
QE3 campaign.

QE3 was radically different from QE1 and QE2 because it was open-ended,
it had no predetermined size or end date like its predecessors. Top Fed officials
deftly used this ambiguity to manipulate psychology among stock traders. They
continually implied the Fed was ready to increase the size of QE3's debt monetizations
if the stock markets suffered any material selloff. The Fed was jawboning stocks
higher.

Stock traders interpreted this endless dovishness exactly as the Fed intended,
believing an effective Fed Put was in place for the stock markets. So
they rushed to aggressively buy already-high stocks, ignoring all conventional
indicators of risk including valuations. That Fed-sparked stampede into
stocks fueled the massive breakout of the SPX above its 13-year-old nominal
resistance near 1500 back in early 2013.

As the stock-market valuations rising sharply in the Fed-SPX-levitation era
since 2013 prove, the huge stock gains weren't the result of improving earnings
fundamentals but merely Fed hot air. With profits failing to grow enough
to justify those lofty stock prices, the fundamental foundation of recent years'
powerful stock bull was totally rotten. Stock valuations were driven
to near-bubble extreme topping territory.

And with the Fed's easy-money policies that inflated the stock markets ending,
the chickens are going to come home to roost. The Fed concluded its new quantitative-easing
bond buying with money conjured out of thin air in October 2014, and it seems
to be on the verge of ending its zero-interest-rate policy kept in place since
December 2008 that fueled those epic corporate stock buybacks seen in recent
years.

And with the vast bullish psychological impact of QE and ZIRP fading, stock-market
valuations are going to mean revert back to their secular downtrend in place
before the Fed goosed the stock markets. The whole purpose of secular stock
bears is to force the markets to grind sideways for long enough to give corporate
earnings time to grow into the extreme stock prices seen at the end
of the preceding secular bull.

This massive 17-year secular-bear grind is accomplished through smaller cyclical
bears and bulls within that span. Secular bears consist of a series of cyclical
bears that first cut stock prices in half, followed by cyclical bulls
that double them back up to breakeven again. Since 2000, we've seen two of
these full cyclical-bull-bear cycles. And as today's dangerous stock-topping
valuations prove, the next bear is imminent.

Thanks to the Fed's gross market distortions in recent years dragging stocks
so far outside of normal trends, this next bear is going to be a doozy. Secular
bears begin with stock valuations near or above bubble levels, and end with
them around half fair value at 7x earnings before the next secular bull can
be born. At this late stage in 17-year secular bears as the valuation downtrend
shows, P/Es should be near 10x.

Based on current corporate earnings, which Wall Street constantly claims are
excellent, the SPX would have to plunge over 60% fromhere to 820! Even
if profits start miraculously growing in this tough world economy, it's hard
to imagine them rising enough in the next couple years to push the SPX much
over 1000 at 10x earnings. The Fed's artificial stock-market levitation that
so stretched valuations will prove disastrous.

Today's stock topping valuations couldn't be more dangerous at this stage
in the great secular bull-bear cycles. SPX valuations are way up near bubble
levels now thanks to the Fed, leaving vast downside to where they ought
to be nearly 16 years into an indisputable ongoing secular bear. Investors
need to be very careful in buying very expensive stocks today despite Wall
Street trying to convince them otherwise.

And frighteningly, the corporate-earnings and therefore valuation situation
may be even worse thanks to the gross Fed distortions of recent years. Corporate
sales, which can't be manipulated like earnings, have been weakening. Companies
can cost-cut their way to profits for a while, but they can't fire everyone
and eventually have to see revenues improve to grow profits. Even stock buybacks
are a temporary stopgap.

As the Fed starts the long
road to normalizing rates after it ends its zero-interest-rate policy,
the virtually-free money companies have been borrowing to buy back stocks
will vanish. Higher borrowing costs will lead to plummeting share buybacks,
which will end the manipulation of spreading overall profits across fewer
outstanding shares year after year. So valuations could stay high or even
climb higher from here.

The stock markets would be extremely expensive at 25.5x earnings even late
in a secular bull market, but they are an accident waiting to happen this late
in a secular bear. Investors ought to prepare for a new cyclical bear market that
will at least cut stock prices in half. The biggest risk is not perceiving
it in time, as bears unfold slowly over a couple years to keep investors lulled
into complacency for as long as possible.

Investors and speculators alike can trade these stock topping valuations by
being ready to liquidate their long stock positions as the stock markets inevitably
roll over. Sliding stock markets can also be bet upon directly through put
options on the leading SPY SPDR S&P 500 ETF. Alternatively, long positions
can be added in gold (GLD ETF) and radically-undervalued
gold stocks, as gold
tends to thrive during stock bear markets.

Whatever you do, with stock markets at such a critical juncture it's exceedingly
important to cultivate strong contrarian sources of analysis to counter Wall
Street's perpetual Pollyannaish bullishness. That's what we specialize in at
Zeal. For 16 years now, we've been intensely studying and trading the markets
from a hardcore contrarian perspective. We buy low when few will, to later
sell high when few can.

You can put our decades of exceptional experience, knowledge, wisdom, and
ongoing research to work helping multiply your wealth through our acclaimed weekly and monthly newsletters
for speculators and investors. They explain what's going on in the markets,
why, and how to trade them with specific stocks. With valuations so extreme
at this stage in the great cycles, now is a great time to subscribe and
get informed!

The bottom line is the US stock markets are trading at dangerous topping valuations.
Despite incredible buybacks fueled by record-low rates courtesy of the Fed,
corporate profits are still so weak relative to Fed-inflated stock prices that
stocks still neared bubble valuations following third-quarter earnings. This
is a huge problem so late in a secular bear, when valuations should be far
closer to 10x earnings than 26x.

This has to end badly. The gross Fed distortions of recent years artificially
extended a mature cyclical bull and delayed a cyclical bear, but central banks
can't eliminate market cycles driven by valuations. The overdue bear market
is still coming, and will be far worse starting from such lofty and overvalued
conditions. Stock topping valuations at these extremes this late in a secular
bear are exceedingly dangerous.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
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